Another Reason Why It’s Time To Rethink ‘Value’…
There’s an academic paper that’s getting a lot of attention among the people I frequently talk to…
It’s called “Eight centuries of global real interest rates, R-G, and the ‘suprasecular’ decline, 1311-2018.”
This technical paper concludes that, since “the late middle ages, a trend decline between 0.6-1.8bps p.a. has prevailed.” In other words, interest rates have been declining by about 0.01% a year for the past 500 years.
An example of the detail in the paper is found the chart below.
Source: Eight centuries of global real interest rates, R-G, and the ‘suprasecular’ decline, 1311-2018
The trend on the chart is clear, and the conclusion makes sense. One obvious reason for the long-term decline is simply that, as laws protecting creditors evolved, there was less risk associated with lending. Thus, rates should decline. Market structure — the ability to trade debt instruments and hedge risks — also accounts for part of the decline.
This is important because it indicates the low interest rates that we have seen for the past 10 years could remain in place for decades. Interest rates could even drop from their current levels.
What This Means
That forces us to reconsider the idea of value investing.
Ben Graham, Warren Buffett’s business school professor, identified a relationship between interest rates and price-to-earnings (P/E) ratios.
Graham explained that the relationship was important because of an indicator known as the earnings yield. The earnings yield is the inverse of the P/E ratio, or the E/P ratio. Because of the inverse relationship, when earnings yields are low, the P/E ratios will be high.
Graham focused on the E/P ratio because it was a direct link to bonds. At the time Graham wrote, stocks competed with bonds for investment capital. To entice investors to buy stocks instead of bonds, the stock needed to have a higher E/P yield than the bond.
For example, if a railroad bond offered a 5% yield, investors in the stock could demand an E/P ratio of 8%. That offers compensation for the risk stocks have relative to bonds. With an E/P ratio of 8%, the P/E ratio of the stock would be 12.5.
Expanding Graham’s analysis, if we view a stock as an alternative to the 10-year Treasury, we have a baseline P/E ratio.
The 10-year yields about 1.8%. This indicates the broad stock market should have an E/P ratio of 1.8% plus a risk premium. If the risk premium is 3%, that tells us the P/E ratio for stocks should be about 21. That’s about where we are now.
Action To Take
But here’s the key… that paper on interest rates tells us risk premiums are dropping. And that indicates P/E ratios could be even higher.
Value investors have long looked for stocks with low P/E ratios. Now, a “low” P/E ratio could be above 20. And if rates fall further, P/E ratios of 30 could offer “value”. This is important to consider as we look at stocks since the definition of value is definitely changing.
Another way to think about value is to look for situations when demand outruns supply by a big factor. And that’s exactly what’s happening with “the most useful metal on earth“…
Most people have NO clue this situation exists right now, but it’s getting serious.
According to our research, the world is running on a 10-day supply of this metal. That’s it. You don’t need a PhD to know that when the supply of something we need is shrinking… and demand is exploding… that prices are primed to soar.